THE GOODS MARKET AND MONEY MARKET: LINKS BETWEEN THEM

• Keynes explains that national income is determined at the level where aggregate demand (C + I) equals aggregate output, i.e., where the goods market is in equilibrium.

• In the simple Keynesian model:

  • Aggregate demand consists of consumption (C) and investment (I).

  • National income is determined where C + I = Output.

  • The equilibrium level of income is thus determined in the goods market.

• Investment (I) in this model:

  • Is determined by the rate of interest and the marginal efficiency of capital (MEC).

  • Is assumed to be independent of the level of national income.

• The rate of interest is determined in the money market by:

  • The demand for money.

  • The supply of money.

  • Equilibrium in the money market.

• Changes in the rate of interest (due to changes in money supply or demand for money):

  • Affect the level of investment.

  • Changes in investment affect aggregate demand (C + I).

  • This leads to changes in national income and output in the goods market.

  • Thus, money market equilibrium influences goods market equilibrium.

• A criticism of the simple Keynesian model:

  • It appears to show only a one-way relationship.

  • Changes in the money market affect the goods market.

  • But there seems to be no reverse effect of changes in income or investment in the goods market on the money market equilibrium.

• J.R. Hicks and other economists addressed this flaw:

  • They argued that changes in income also affect the money market.

  • Higher income increases the transactions demand for money.

  • Changes in money demand influence the rate of interest.

  • Therefore, there is a two-way relationship between goods and money markets.

• According to Hicks:

  • The level of income, determined by consumption and investment, affects money demand.

  • Money demand influences the rate of interest.

  • Hence, goods market changes indirectly influence the money market.

• Economists such as Hicks, Hansen, Lerner, and Johnson developed a more complete and integrated framework:

  • Known as the IS–LM model.

  • It shows the mutual interdependence of:

    • Investment

    • National income

    • Rate of interest

    • Demand for money

    • Supply of money

• The model is represented by two curves:

  • The IS curve (goods market equilibrium).

  • The LM curve (money market equilibrium).

• The IS–LM model demonstrates:

  • Simultaneous equilibrium in both goods and money markets.

  • Joint determination of national income and the rate of interest.

• The IS–LM framework has become a standard tool of macroeconomics.

  • It is widely used to analyze the effects of monetary policy.

  • It is also used to examine the impact of fiscal policy.

GOODS MARKET EQUILIBRIUM : THE DERIVATION OF THE IS CURVE

• The IS–LM model emphasizes the interaction between the goods market and the money market.

• The goods market is in equilibrium when aggregate demand = national income.

• Aggregate demand consists of:

  • Consumption demand (C)

  • Investment demand (I)

• In the extended Keynesian framework:

  • The rate of interest is introduced as an important determinant of investment.

  • Investment becomes an endogenous variable.

  • A fall in the rate of interest leads to an increase in investment.

  • A rise in the rate of interest reduces investment.

• Mechanism of interest affecting income:

  • A lower rate of interest reduces the cost of investment projects.

  • This raises the profitability of investment.

  • Businessmen undertake greater investment.

  • Increased investment raises aggregate demand (C + I).

  • Higher aggregate demand leads to a higher equilibrium level of national income.

• In deriving the IS curve:

  • We determine equilibrium levels of national income corresponding to different rates of interest.

  • Each equilibrium income level is based on goods market equilibrium with investment determined by a given rate of interest.

  • Thus, the IS curve shows the relationship between rate of interest and equilibrium national income.

• Explanation using graphical panels:

  • In panel (a):

    • The relationship between rate of interest and planned investment is shown by the investment demand curve.

    • At interest rate Or₀, planned investment equals OI₀.

  • In panel (b):

    • With planned investment O*I₀, aggregate demand is C + I₀.

    • Goods market equilibrium occurs at income level O*Y₀.

  • In panel (c):

    • The combination of Or₀ and OY₀ is plotted.

• When the rate of interest falls to O*r₁:

  • Planned investment rises from OI₀ to OI₁.

  • Aggregate demand shifts upward from C + I₀ to C + I₁.

  • Goods market equilibrium rises to income level O*Y₁.

  • The combination Or₁ and OY₁ is plotted.

• With a further fall in interest rate to O*r₂:

  • Planned investment increases to O*I₂.

  • Aggregate demand shifts further upward to C + I₂.

  • Goods market equilibrium occurs at income level O*Y₂.

  • The combination Or₂ and OY₂ is plotted.

• By joining points representing different interest–income combinations (such as A, B, D), we derive the IS curve.

• The IS curve:

  • Is the locus of combinations of rate of interest and national income at which the goods market is in equilibrium.

  • Is downward sloping (negative slope).

  • Indicates that a fall in the rate of interest leads to a rise in the equilibrium level of national income.

Why does IS Curve Slope Downward?

• The lower the rate of interest, the higher will be the equilibrium level of national income.

• The IS curve is the locus of combinations of rate of interest and national income at which the goods market is in equilibrium.

• Derivation of the IS curve (as illustrated in Fig. 12.1):

  • In panel (a):

    • The relationship between rate of interest and planned investment is shown by the investment demand curve (II).

    • At interest rate Or₀, planned investment equals OI₀.

  • In panel (b):

    • With planned investment OI₀, the aggregate demand curve becomes C + I₀.

    • Aggregate demand equals aggregate output at income level OY₀.

    • Thus, the goods market is in equilibrium at OY₀.

  • In panel (c):

    • The combination of Or₀ (interest rate) and OY₀ (income level) is plotted.

• When the rate of interest falls to Or₁:

  • Planned investment increases from OI₀ to OI₁ (panel a).

  • The aggregate demand curve shifts upward from C + I₀ to C + I₁ (panel b).

  • Goods market equilibrium rises to income level OY₁.

  • The combination Or₁ and OY₁ is plotted in panel (c).

• With a further fall in the rate of interest to Or₂:

  • Planned investment increases to OI₂ (panel a).

  • Aggregate demand shifts upward to C + I₂ (panel b).

  • Goods market equilibrium occurs at income level OY₂.

  • The combination Or₂ and OY₂ is plotted in panel (c).

• By joining points A, B, and D representing different interest–income combinations, the IS curve is obtained.

• The IS curve:

  • Is downward sloping (negative slope).

  • Shows an inverse relationship between rate of interest and equilibrium national income.

  • Implies that a decline in the rate of interest leads to an increase in the equilibrium level of national income.